You need money but you’re not sure where to get it.
You’ve exhausted all of your other sources. You’ve maxed out your credit cards; you don’t qualify for any more loans. So what can you do?
Your 401k account has a balance in it and that balance is looking pretty good…be careful though, there can be some problems with tapping into your 401k plan too early.
Tapping Into Your 401k Too Early
If you tap into your 401k account early it can get expensive, unless you use the right distribution option. If you use the wrong distribution option, the fees, penalties and taxes that you get hit with sometimes doesn’t justify your reasons for needing the money.
Because of the expense you may want to rethink your need for the money and the reasons you have been investing into your 401k plan. Your 401k plan is for one purpose and one purpose only.
401k plans were established as an investment tool for saving money for retirement. The IRS & the Department of Labor (DOL) established 401k plans to help you on a tax deferred basis to save for your retirement.
If you tap into your 401k plan before retirement, the IRS & Department of Labor (DOL) feel justified in penalizing you and taxing you since you aren’t using your 401k plan for its intended use.The IRS has established distribution options. Due to different rules and regulations some distribution options are more expensive than others.
Your 401k Distribution Options
# 1 – Cash Out 401k Option
The cash out 401k option can be expensive. If you cash out of your 401k plan before the age that the IRS & DOL considers “retirement age” they will tax and penalize you.
- Age 59 1/2 is consider “retirement age” by the IRS.
- If you dip into your 401k account before age 59 ½ , the one 401k distribution option where you will be taxed and penalized is the cash out 401k option.
- With the cash out 401k option, you are basically making a 401k withdrawal. The cash out option is not a 401k transfer, it’s a 401k rollover.
- The IRS treats the 401k cash out option differently than they treat a 401k transfer or rollover. The money that is invested in your 401k plan has never been taxed – so when you cash it out – it must be taxed.
- The IRS penalizes the cash out option because 401k’s are for your retirement. You could pay 10% penalties.
To encourage you to use it for retirement purposes, the IRS feels a penalty is appropriate when you use your 401k for reasons other than retirement at retirement age. If you like wasting money on taxes and penalties then the cash out 401k option is the distribution option for you.
#2 – 401k Transfers & 401k Rollovers
You may roll over your 401k account balances to a new employers 401k plan or an individual retirement plan. You will not be taxed or pay 10% penalties when you rollover or transfer your 401k account balance, if you do a direct plan transfer.
- A direct plan transfer, sometimes called a trustee-to-trustee transfer is when you do not handle the money.
- The financial institutions handle the transfer money.
- The distribution check is sent directly from one financial institution to the other.
- There is a 2nd rollover option where you actually receive the distribution check.
- Be careful with this rollover option because you only have 60 days of receiving the check to redeposit it back into another 401k plan or IRA.
- If you do not redeposit the rollover check within 60 days, you will be taxed and have to pay a 10% penalty.
- You can only implement a 401k rollover or 401k transfer when you leave employment by way of a job change or retirement.
- If you implement a 401k rollover or transfer before leaving a job or retiring, the Department of Labor and the IRS considers it a distribution and you will be taxed plus incur a 10% penalty.
#3 – 401k Withdrawals
- A 401k withdrawal before age 59 1/2 is another expensive distribution option.
- You will be taxed on the withdrawal amount, unless you are over age 59 1/2.
- You may also be penalized if under age 59 1/2.
- The IRS does allow for 401k Hardship Withdrawals, but you have to meet one of the 5 reasons to quality.
- Also, employers are not required to include the Hardship Withdrawal option in your plan; check with your 401k plan administrator.
- 401k hardship withdrawals are subject to taxes.
- If you are under age 59 1/2, you will incur the 10% penalty.
#4 – 401k Hardship Withdrawals
- Purchase of a new principal residence.
- For the payment of higher education expenses.
- Non-reimbursed medical expenses.
- Payment to prevent eviction from your home.
- To pay for funeral expenses.
You do have options with your 401k account when you need money; which one you choose to use is up to you. Just make sure you do some research before you tap into your 401k plan; learn the costs involved. Maybe you qualify for a hardship loan, maybe your almost age 59 1/2, so waiting would save you lots of money on taxes and penalties.